2nd CEPR-Imperial-Plato Market Innovator (MI3) Conference 2018

Once upon a broker time? Order preferencing and market quality

Hans Degryse (KU Leuven)

Nikolaos Karagiannis (KU Leuven)

Hans Dergryse is a research professor at KU Leuven, a research university in Flanders. Previously a professor of financial intermediation and markets at CentER-Tilburg University, his research is predominantly focused on banking systems, competition, corporate finance and financial markets. Nikolaos Karagiannis works in the Finance Research Centre, also at Leuven.

About the paper

While liquid stocks mostly trade on competing limit order books, other assets including corporate bonds, government bonds, derivatives etc. are traded in over-the-counter (OTC) markets. The question resulting from this is whether there is a ‘one size fits all’ priority rule in trading, or whether priority rules should be adjusted according to the fundamentals of an asset or market structure.

Hans Dergryse and Nikolaos Karagiannis set out to compare order preferencing in order to determine how priority rules determine market quality and investor welfare.

In this case, order preferencing is modelled as price-broker-time priority (PBT) and comparing it to price-time priority (PT). Currently, PT is the leading allocation rule in most markets, but PBT is currently in place on some important venues including Canada, Australia and the Nordics.

The paper studies which priority rule prevails in unregulated financial markets by offering brokers the individual choice to adopt PBT or opt for PR. Hans Degryse and Nikolaos Karagiannis investigate whether this market outcome aligns with the social planner’s preferred outcome, and whether regulatory intervention is required.

Priority rules in the limit order book generate systematic patterns in trade and order flow. With PT, an investor’s broker-affiliation does not impact order submission strategies. The paper highlights how priority rules may explain market fragmentation and dark trading, in particular off-exchange reporting of trades.

Priority rules impact market depth. Markets with PT have a higher average depth than with PBT. Limit order books are shallow (i.e. empty) and ‘deep’ (i.e. depth of 2) are more prevalent with PBT compared to PT.

Priority rules determine trading rates, the composition of trades as well as the fill rates of LOs. The effect depends on the size of the minimum tick, as this determines arriving traders’ decisions to participate in the market as well as decisions to go for market limit orders. When the tick is small, trading rates are higher with PBT compared to PT.

The paper has regulatory implications by illustrating that imposing a unique trading protocol on widely heterogeneous financial markets is not optimal. While PT leads to greater welfare for markets with high liquidity, allowing for other trading protocols such as PBT may be preferred for markets exhibiting lower market quality.

Conclusion

The paper compares the impact on market quality and investor welfare of two different allocation rules commonly observed in financial markets – PBT and PT.

Priority rules are an important driver of how markets may fragment. The model put together by Hans Degryse and Nikolaos Karagiannis predicts that brokers can circumvent PT trading protocols by reporting trades off-exchange.

This identifies one of the driving forces which push traders away from lit markets.